If you receive a below-market gift or demand loan and use the
proceeds in your trade or business, you may be able to deduct the
forgone interest. See Treatment of gift and demand loans
later in this discussion.
A below-market loan is a loan on which no interest is
charged or on which interest is charged at a rate below the applicable
federal rate. A gift or demand loan that is a below-market loan
generally is considered an arm's-length transaction in which you, the
borrower, are considered as having received both the following.
- A loan in exchange for a note that requires the payment of
interest at the applicable federal rate.
- An additional payment.
The additional payment is treated as a gift, dividend,
contribution to capital, payment of compensation, or other payment,
depending on the substance of the transaction.
For any period, forgone interest
- The interest that would be payable for that period if
interest accrued on the loan at the applicable federal rate and was
payable annually on December 31,
- Any interest actually payable on the loan for the
Applicable federal rates are published by the IRS each month in the
Internal Revenue Bulletin. Internal Revenue Bulletins are available on
the IRS web site at www.irs.gov.You can also contact an IRS
office to get these rates.
Loans subject to the rules.
The rules for below-market loans apply to the following.
- Gift loans (below-market loans where the forgone interest is
in the nature of a gift).
- Compensation-related loans (below-market loans between an
employer and an employee or between an independent contractor and a
person for whom the contractor provides services).
- Corporation-shareholder loans.
- Tax avoidance loans (below-market loans where the avoidance
of federal tax is one of the main purposes of the interest
- Loans to qualified continuing care facilities under a
continuing care contract (made after October 11, 1985).
Except as noted in (5) above, these rules apply to demand
loans (loans payable in full at any time upon the lender's
demand) outstanding after June 6, 1984, and to term loans
(loans that are not demand loans) made after that date.
Treatment of gift and demand loans.
If you receive a below-market gift loan or demand loan, you are
treated as receiving an additional payment (as a gift, dividend, etc.)
equal to the forgone interest on the loan. You are then treated as
transferring this amount back to the lender as interest. These
transfers are considered to occur annually, generally on December 31.
If you use the loan proceeds in your trade or business, you can deduct
the forgone interest each year as a business interest expense. The
lender must report it as interest income.
Limit on forgone interest for gift loans of $100,000 or less.
For gift loans between individuals, forgone interest treated as
transferred back to the lender is limited to the borrower's net
investment income for the year. This limit applies if the outstanding
loans between the lender and borrower total $100,000 or less. If the
borrower's net investment income is $1,000 or less, it is treated as
zero. This limit does not apply to a loan if the avoidance of any
federal tax is one of the main purposes of the interest arrangement.
Treatment of term loans.
If you receive a below-market term loan other than a gift loan, you
are treated as receiving an additional cash payment (as a dividend,
etc.) on the date the loan is made. This payment is equal to the loan
amount minus the present value, at the applicable federal rate, of all
payments due under the loan. The same amount is treated as original
issue discount on the loan. See Original issue discount (OID)
under Interest You Can Deduct, earlier.
Exceptions for loans of $10,000 or less.
The rules for below-market loans do not apply to certain loans on
days on which the total outstanding loans between the borrower and
lender is $10,000 or less. This exception applies only to the
- Gift loans between individuals if the loan is not directly
used to buy or carry income-producing assets.
- Compensation-related loans or corporation-shareholder loans
if the avoidance of any federal tax is not a principal purpose of the
This exception does not apply to a term loan described in (2)
above that was previously subject to the below-market loan rules.
Those rules will continue to apply even if the outstanding balance is
reduced to $10,000 or less.
Exceptions for loans without significant tax effect.
The following loans are specifically exempted from the rules for
below-market loans because their interest arrangements do not have a
significant effect on the federal tax liability of the borrower or the
- Loans made available by lenders to the general public on the
same terms and conditions that are consistent with the lender's
customary business practices.
- Loans subsidized by a federal, state, or municipal
government that are made available under a program of general
application to the public.
- Certain employee-relocation loans.
- Certain loans to or from a foreign person, unless the
interest income would be effectively connected with the conduct of a
U.S. trade or business and not exempt from U.S. tax under an income
- Any other loan if the taxpayer can show that the interest
arrangement has no significant effect on the federal tax liability of
the lender or the borrower. Whether an interest arrangement has a
significant effect on the federal tax liability of the lender or the
borrower will be determined by all the facts and circumstances.
Consider all the following factors.
- Whether items of income and deduction generated by the loan
offset each other.
- The amount of the items.
- The cost of complying with the below-market loan provisions
if they were to apply.
- Any reasons, other than taxes, for structuring the
transaction as a below-market loan.
Exception for certain loans to a qualified continuing care
The below-market interest rules do not apply to a loan made to a
qualified continuing care facility under a continuing care contract if
the lender (or lender's spouse) is age 65 or older by the end of the
calendar year. For 2001, this exception applies only to the part of
the total outstanding loans from the lender (or lender's spouse) that
does not exceed $144,100.
A qualified continuing care facility is one or more
facilities that are designed to provide services under continuing care
contracts and where substantially all the residents have entered into
continuing care contracts. In addition, substantially all the
facilities used to provide services required under the continuing care
contract must be owned or operated by the loan borrower.
A continuing care contract is a written contract between
an individual and a qualified continuing care facility that meets all
the following conditions.
- The individual and/or the individual's spouse must be
entitled to use the facility for the rest of their life or
- The residential use must begin in a separate, independent
living unit provided by the continuing care facility and continue
until the individual (or individual's spouse) is incapable of living
independently. The facility must provide various "personal care"
services to the resident such as maintenance of the residential unit,
meals, and daily aid and supervision relating to routine medical
- The facility must be obligated to provide long-term nursing
care if the resident is no longer capable of living
- The contract must require the facility to provide the
"personal services" and "long-term nursing care" without
substantial additional cost to the individual.
Sale or exchange of property.
Different rules generally apply to a loan connected with the sale
or exchange of property. If the loan does not provide adequate stated
interest, part of the principal payment may be considered interest.
However, there are exceptions that may require you to apply the
below-market interest rate rules to these loans. See Unstated
Interest and Original Issue Discount in Publication 537.
For more information on below-market loans, see section 7872 of the
Internal Revenue Code and section 1.7872-5T of the regulations.
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